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P/E ratios are of little value in choosing growth stocks


Are you on the side that believes a stock with a low price-to-earnings ratio is a bargain and a stock with a high P/E is considered expensive? Here’s another way to look at it when looking for stocks.




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The P/E ratio is usually calculated by dividing a stock’s current price by its earnings per share over the past 12 months.

A common belief is that stocks with low P/E ratios are undervalued and should be bought, while stocks with high P/E ratios are overvalued and should be avoided.

History shows that higher P/E ratios are commonly found in bull markets, while lower ratios are found in bear markets. The one exception is cyclical stocks: They can have lower P/Es even in bull markets.

You reap what you sow

Quality goods come with a higher price tag, and the same can be said for inventory.

Stock prices reflect the perceived value of the stock by investors, which is dependent on supply and demand. If investors feel a stock has strong earnings growth potential, they will push the stock price higher.

A higher price leads to a higher P/E, because price is the numerator in the ratio. Companies with stagnant earnings growth and no catalyst to push their stocks higher won’t be a bargain if their prices don’t rise.

Large growth stocks with large P/E ratios

In his book “How to Make Money in Stocks,” IBD founder William O’Neil says the P/E ratio won’t tell you whether a stock’s price will go up or down, and it isn’t. factor in buying stocks. A better measure is to accelerate or drastically increase earnings per share growth.

By looking at historical winners over the decades, if you sift through stocks with P/Es greater than the market average, you’re missing out on big opportunities. O’Neil’s studies show that from 1953 to 1985, the best performing stocks had an average P/E of 20 when they started to profit. The Dow Jones Industrial Average had an average P/E of 15 over the same period.

When these stocks started to appreciate, their P/E ratios increased to about 45.

It was even more apparent from 1990 to 1995, when the top growth stocks had an average P/E of 36, and until the 80s. The best performers started with ratios in the range. vi 25-50 and rises to a peak of 60-115. As you can imagine, it was even more dramatic in the late 1990s when valuations skyrocketed.

If you skip Microsoft (MSFT) in 2021 due to a higher-than-average P/E ratio, you will miss two opportunities. First, stocks break out of a cup base on the week of June 25 when its P/E ratio was 37. The stock rallied 16% until peaking in August and starting to make a new base.

If you miss that buy point, there’s another breakout coming the week of October 22, when Microsoft’s P/E was 39. The stock rallied 14% to an all-time high in November.

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